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Why I Can't Stomach Chipotle's Weak Comps

I won't dispute that the company makes the perfect burrito, but the stock has been priced for perfection for some time. But the execution has been anything but flawless.

With rising costs of beef weighing on Chipotle's margins to go along with weakening same-store sales, it's become hard to stomach the stock price, which carries a price-to-earnings ratio twice that of McDonald's and almost double the multiple of Yum! Brands -- it doesn't make sense. Today, on the heels of the company's first-quarter earnings report, these concerns are even more glaring.

Comps, or another way to say comparable same-store sales, is the metric that tracks the performances of restaurants opened at least one year. Unfortunately for Chipotle, the company has been underperforming in that area, which suggests that these restaurants are seeing a decrease in customer traffic. More than anything, this has been my biggest source of concern with this company.

Chipotle, which at one point traded as high as $419, was doing very well in this metric. The company posted comps of 11.1% two years ago, which was then more than double that of several bigger rivals. Since then, comps have been on a steady decline -- dropping to 8% in the second quarter of 2012, and then falling to 4.8% in the third quarter of last year, which then culminated to comps of 3.8% in the company's fiscal fourth-quarter report in February.

Unfortunately, comps have taken a turn for the worse -- falling to 1% this quarter. Remarkably, Chipotle is being outperformed by Yum! Brands, which recently posted a 2% increase in U.S. comps. The comparison with Yum!'s U.S. business is because Chipotle does not have an international strategy. For Yum!, though, the company still manage to advance comps despite the onslaught of bad publicity that Yum! has had to endure regarding avian and bird flu. So it's hard to cut Chipotle any slack.

First quarter revenue did arrive better than expected, 13% higher year-over-year and 4% higher sequentially. Given the soft patch that McDonald's has experienced, the fact that Chipotle is still posting double-digit percentage growth is no small compliment -- this, I'm willing to admit. But to the extent that a 13% increase in revenue makes up for hemorrhaging comps, I just don't see it that way. Not when the stock's valuation presumes perfection.

Meanwhile, profitability wasn't any better. Restaurant level operating margin was 26.3% falling 110 basis points year over year. Here again, the company shows increased signs of struggle from higher food costs. This is the second consecutive quarter of margin erosion after the company shed 150 basis points in the fourth quarter.

I've made this point once before: Food costs took 33% of Chipotle's revenue is a cause for indigestion. As long as food costs remain at such a high percentage of revenue, this will continue to add pressure on management to raise menu prices. The good news here is that the 33% in this quarter is 50 basis points lower than what Chipotle reported in the fourth quarter, which led to a 16.5% jump in operating income.

How Well Is the Strategy Growth Working?

This is the million-dollar question. Management believes in its aggressive growth objectives. That's all well and good. But at some point this business will need to slow its expansion strategy and focus on current operations. The company plans to open 165 to 180 new restaurants this year. Meanwhile, there are no signs that food costs are going to stop rising.

To that end, McDonald's, which once seemed impervious to such macro matters has recently decided to remove its Angus third-pounder from its menu by the middle of next month. In other words, McDonald's is seeing no cost-benefit to keep selling the burgers while the costs of beef continue to rise. Plus, given the fact that Chipotle's menu items were already selling at a premium to McDonald's menu, how will Chipotle respond?

Can management justify raising prices while at the same time risking an already dire comps situation? I don't believe the company has a choice. If it still plans to open the number of stores, these costs will need to be offset somehow. And given the unpredictable nature regarding food costs, this (at least) is one area of its execution it can control. The unknown here, is how customers will respond.

Bottom Line

If management can figure out a way to reverse the decline in comps and margins, then I'd reconsider my bearishness. But in the meantime, I'm going to continue to enjoy Chipotle's food, which is delicious, by the way! The stock, however, is anything but digestible at this level.

At the time of publication, the author held no position in any of the stocks mentioned.